The Venture Capital Paradox

How and why the VC landscape has evolved - and what that means for founders

I recently spoke to a friend of mine who worked with me at Gorillas. He posed a question I’ve heard often over the last year: Why are the financing tradeoffs for startups so stark? Why aren’t there middling amounts of equity available to modestly sized (and risked) businesses?

Particularly in light of the recent tech sell-off, many current and former founders I’ve talked to have begun to question the role of venture capital. VC has become a massive, institutionalized market when its capital structure only really supports a very specific type of fast growing, potentially massive scale business. 

In this post, I’ll unpack why venture capital has developed into the force we know today and why the elusive mid-sized modern business doesn’t have a natural capital market to support it. I’ll also talk a bit about the implication this system has on founders.

Some caveats: I’ve spent some time in and around venture capital, but I don’t claim to be an expert. I’ll share my best attempt at a data-driven (and hopefully accessible) explanation for the modern venture capital system, but there are always exceptions to these rules.

Consider an old-world business: a corner shop. The owner needs a bit of capital to get the business started but has a pretty good idea of what and how much he’ll sell. The only revenue will come in the form of sales to customers during opening hours when the owner is working. In other words, the business isn’t super risky, and it also has limited upside. 

Taking debt makes sense: the owner doesn’t have enough money to get started, so he borrows some from the bank. When the owner makes money, he’ll pay down the debt. If he can’t repay the bank, then the bank can seize some collateral (inventory, real estate) to sell for the cash.

Some businesses have less certain outcomes. Many will fail, and in those cases banks wouldn’t get paid back. As a result of that uncertainty for lenders, debt won’t work. Instead, those companies turn to equity: essentially a division of ownership over the company that shares in all future profits and losses. 

It’s an elegant funding model for risky businesses; without equity, most modern technology businesses wouldn’t exist. While a number of different equity asset classes exist, venture capital is the one known for seeding new and uncertain businesses. 

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But given that it’s possible - even likely - that the capital provider doesn’t see its money back, it needs to ensure that, on average, its investments are successful. Which is another way of saying that the companies it invests in need to succeed. Interests are theoretically aligned: investors benefit when their companies perform.

Here’s where it becomes counterintuitive. Investors have realized that most of these companies fail but don’t know which ones, at the outset. So rather than trying to be right more often than not, investors have focused on making sure that the winners are as big as possible. Over a 30 year period, Andreessen Horowitz found that only 6% of startups accounted for a majority of returns, a dynamic referred to as the power law of venture capital.

Interestingly, this pattern continues at the investor level: the top-performing venture funds aren’t any more accurate with their bets than the median. Rather, the top funds simply managed to invest in the most successful startup companies (top performers return 90% of returns). 

This creates a very particular incentive for venture investors: all that matters is finding and investing in the companies that have the potential to become a generational company. Given that the success rate of early stage venture-backed companies is low, a venture fund will likely find its generational startup if it simply places enough bets.

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That’s how modern venture capital has evolved. Large amounts of capital need to find big bets to cover the losses that are practically guaranteed in venture investing. Can a startup raise venture investing and sell for a middling exit? Yes. But it’s hard to raise money in the first place if you’re not striving to deliver a potentially massive return to your investors. 

Investors push their portfolio companies to grow faster because mediocre exits, though potentially life-changing for founders, hold little value to venture capital firms. They’d rather founders take the risk of becoming generational even though many will fail in that effort.

Life-changing financial outcomes for founders occur at exit prices far lower than what venture investors care about. While both investors and founders theoretically are incentivized by company success, each side’s economic reward results in a possible alignment issue.

You may be wondering if we could build a different ecosystem, one that supports ambitious tech companies across the spectrum of financial outcomes. And there are efforts at creating that dynamic, for specific use cases: Capchase offers non-dilutive, revenue-based financing for SaaS companies. Bonside is doing something similar for brick-and-mortar companies as they scale. Story Capital is leveraging technology to substantially grow cash-flowing businesses that they acquire. Most of all, AI will enable founders to build more with less capital - a potentially existential threat to the venture ecosystem. 

I applaud these attempts, but none (except for AI, which deserves its own piece) address the issue of seeding companies in the first place. The harsh tradeoffs founders make at the outset of their journey still persist because of the nature of startup outcomes - not the other way around. If venture capital didn’t exist, we wouldn’t have the dynamic entrepreneurship ecosystem that we do. I recognize the downsides, and founders should think carefully before they take venture capital. But it’s definitely better than nothing. 

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So why did I write all of this, just to end up at the conclusion that the current system is pretty good despite some drawbacks? Because while the system works well to produce startups, I don’t think we’ve done everything we can to support founders themselves. 

Investors spread their bets because they know most startups fail. Founders don’t, but are obviously necessary to investors’ outcomes. So investors benefit from the power law, whereas most founders suffer from it. The few that succeed become extremely wealthy.

But most founders spend several years trying to make their startup work, paying themselves well below market rate, just to end up winding down their startup. Or even worse, and surprisingly common: selling the company and returning money to investors, but ending up with no personal return.

You may argue that founders deserve their outcome. I don’t dispute that. But founders usually don’t know which category they’re in for several years. If investors had any better idea, they wouldn’t need to diversify. Often, exceptional founders are derailed by factors beyond their control. (Even the most successful founders admit that timing is everything). 

That founders can spend several years trying to solve a challenging problem is a reward unto itself. Even (or especially) failure comes with learning and opportunity. But you can’t eat learning and opportunity any more than you can eat equity. Nor can you pay rent, or support your kids. And there’s a hidden cost of entrepreneurship: most founders report mental health issues, with financial stress listed as a major factor. Nearly half of all founders are considering leaving their startup. 

Contrary to conventional thinking, the median unicorn founder started the company at age 34 - not 24. Most people at that age tend to have life responsibilities beyond themselves. When you take a bet that you'll be the rare founder with a positive financial outcome, you’re bringing your family and dependents along with you. An important implication emerges: many founders best positioned to start successful companies are not able to take that bet. 

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Yet, investors need founders to take that bet. And so does society, because entrepreneurship is vital to solving challenging and important problems. The venture ecosystem, while frustrating, is set up to create enormous amounts of value. But if founders are the most essential part of the ecosystem, why do they and their families bear the most financial risk? Why must they be subjected to the highest levels of stress?

By virtue of placing only one bet, the most successful founders become even wealthier than the top investors. But we’re talking about levels of personal wealth in the billions. Most founders start companies to solve problems that matter, not for the extremely slight chance of becoming a billionaire. They are undoubtedly intrigued by the possibility of outsized gains, but not at the expense of supporting their family.

I don’t think we can or should completely re-align incentives in entrepreneurship. But I do think we can create new rules in venture capital that support founders and create a healthier and more dynamic environment for the real engine in the whole ecosystem: founders. More to come on how I’m tackling the solution later, but this is why I care about the problem in the first place.